The emerging green economy, green investing, and the roles of climate science, policy, and trends.

Your Portfolio Is Hooked on Fossil Fuels

You are drilling for oil
and natural gas, and you probably don’t even know it. What, you say you’ve never near a drilling
rig, and aren’t even sure what one looks like?
You’re still drilling, because companies you own are drilling.

Many financial advisors
and asset managers routinely assume that broadly diversified stock portfolios
will have holdings in fossil fuels companies.
Even most stock mutual funds that identify themselves as ‘green’ funds
contain natural gas and even oil holdings.

This is not only morally
questionable, it’s also likely to lead to disappointing returns. If the goal of investing is to grow assets,
accrue wealth, and prepare for our futures, then it’s key to invest in
companies, industries and sectors that will still be there and growing in that
future. Similarly, our collective macroeconomic goals shouldn’t be to keep the
economy ticking along for the next quarter or current political term, but to
keep it healthy so we may thrive for decades if not centuries. Fossil fuels companies
fail on both these fronts: they face an uphill battle trying to grow into the
medium and long term, and, for many reasons, they also hinder our chances of
achieving economy-wide long-term economic growth, which limits your and my
chances of positive portfolio returns.

We at Green Alpha believe
that fossil fuels have no place in portfolios designed to capitalize on the
emerging, sustainable, green, thriving next economy. We picture and model,
rather, a next economy comprised of enterprises whose technologies, material
inputs, and/or practices have not proven deleterious to the environmental underpinnings
of the global economy; and, equally important, those whose businesses have a
better than average probability of keeping economic production running close to
capacity (meaning close to full employment and therefore causing sufficient
economic demand to keep economies healthy). Healthy, innovative economies made
up of healthy companies have always proven better for portfolio performance. Next
economy companies are innovation leaders in all areas, not just in the energy
industries; they exist now and will continue to emerge in all economic sectors,
providing all products, goods and services required to have a fully
functioning, even thriving global economy. And we believe that next economy
companies will continue to win market share from legacy firms, and that they
therefore provide superior odds of delivering long term competitive returns.

There are several key
reasons this should be the case. As a global economy, we can no longer afford
to wait for our basic economic underpinnings to break before we fix them. Too
many issues, economy wide, from agriculture to water to warming, all damaged by
fossil fuels, have been ignored and left to degrade. By now it’s clear that
fossil fuels, including natural gas, do not result in us growing a thriving next
economy. Between greenhouse gas emissions, toxic emissions (such as mercury),
accidents, spills and contamination of soil, groundwater and oceans, to say
they have proven deleterious to our environmental-macroeconomic underpinnings
is an understatement. We need to make sure the earth’s basic systems - which
global economies rely upon - keep on functioning. And the time to do that is
now, while they’re still working.

Fortunately, as a global
economy we are now (for the first time since the beginning of the industrial
revolution) in a position to begin transitioning to methods that will allow us
to run sustainably using advancements like far cheaper and more beneficial
sources of energy. As inexpensive, unlimited renewables gain more market share,
fossil fuels by definition will be losing market share, meaning stocks of
companies providing the most economically competitive renewables will be in a
better position to deliver superior stock performance than will oil, coal or
even natural gas. Indeed, Shell Oil has recently projected that renewables will eclipse oil as society’s primary source of energy,
making up as much as 40% of all energy used within the next 47 years. Considering
the booming growth of renewables in recent years (particularly solar), I
wouldn’t be surprised if this occurs much sooner; but in any case the writing
is now officially on the wall. Fossil fuels have already begun to lose market
share to renewables. In 2012, most new electricity
generating capacity brought online in the United
States was from renewables, and in January
2013,
all new U.S. electrical generating capacity was provided by renewables. If these trends are
even close to future outcomes, Shell’s prediction will have proven far too
optimistic for the future of oil.

Further, from a stock valuation point of view
it has also become clear that shares of fossil fuels companies have become far
more risky as an asset class than they were even a few years ago. Most policy
observers believe that within a few years there will be a worldwide price on
carbon via some combination of carbon taxes, cap-and-trade schemes and/or
requirements to sequester carbon via ‘capture and storage’ technologies. When
these emerge in large ways, they will represent new systemic costs of business for
fossil fuels companies that will potentially badly damage their margins. In
addition, in a potentially more financially perilous risk, there is the ongoing
specter incredibly expensive damage from accidents associated with fossil
fuels. For example, look at BP’s management’s and shareholders’ objections to settlements
and potential further judicially mandated costs and penalties relating to the 2010
Deepwater Horizon spill (above and beyond the $20 billion trust already established by BP). BP's tortured arguments and huge efforts to
avoid further financial liability for an accident for which they clearly are
partially responsible reveals
the devastating risks the oil industry will be facing as it reaches ever
further for product. BP’s continuing
potential liabilities from this one incident, including “uncapped class-action settlements with
private plaintiffs” and “civil charges brought
by the Justice Department” and “a gross negligence finding [that] could nearly
quadruple the civil damages owed by BP under the Clean Water Act to $21
billion” among others, show, more than anything, that oil as an
asset class is becoming a subprime investment.

All
this being the case, why are fossil fuels companies’ stocks considered
mandatory holdings by many professional money managers and investment banks? The
primary answer is ‘modern portfolio theory;’ that body of knowledge regarding
how to build diversified portfolios of stocks taught at MBA and finance
departments all over the world and considered sacrosanct by most practitioners.
There are good reasons modern portfolio theory (MPT) is so widely practiced, mainly that its underlying goal, to maximize return
for a given level of financial risk, is any portfolio manager’s ultimate duty.
MPT asserts that the way to achieve this is to have appropriate portfolio
exposure to various asset classes like cash, bonds, stocks, commodities, and
from there to follow the proscribed allocation to specific sectors and
industries within these groups in order to achieve the most “efficient
frontier” mix of securities. The sectors proscribed by modern portfolio theory,
as it is typically practiced, include fossil fuels such as oil and gas. But
let’s recall that this theory was pioneered in the 1930s, and was considered
more or less perfected by Harry Markowitz in the 1950s, culminating in his 1959 book “PORTFOLIO SELECTIONEFFICIENT DIVERSIFICATION
OF INVESTMENTS.” For Markowitz and his predecessors,
fossil fuels were the only visible source of energy sufficient to power
society, and by requiring portfolio allocations to these industries, they were
effectively making sure investors got in on the profitable business of what was
really the only energy available. Modern portfolio theory’s
asset allocation models were made for and reflect a world where fossil fuels
were the only imaginable primary power source. Moreover, in the 1950s, there
were fewer material resource constraints, a far lower global population, the
word ‘scarcity’ did not apply to the natural world, and no one had heard of
climate change or global warming, so there really were no reasons to think
twice about fossil fuels or to imagine reasons their returns could be at risk.
But we don’t live in that world anymore.

Building a Fossil Fuels Free Portfolio

Next economy
portfolio theory differs from MPT by recognizing that we live in an economy
that no longer resembles the world of the 1950s. Where modern portfolio theory
defines risk as financial risk only, next economy theory is also concerned with
the risks of earth’s support systems failing. Where modern portfolio theory
says to invest in oil and coal, then, next economy theory says to look for
primary energy replacements that have not proven damaging to the environment to
a degree where they disrupt economics and even society.

And in realizing
that energy now means far more than it did in Markowitz’s day, and by observing
that many if not all economic sectors from transportation to agriculture could
be run in a sustainable fashion, largely using current technologies and
approaches, we build portfolios comprised of next economy companies. This in
turn helps the green economy to continue to accelerate, and provides clients
with opportunity for competitive returns. Investing in the growing technologies of the
future just makes better common sense than investing in the riskier, slowly
shrinking technologies of the past.

Where modern portfolio theory says, ‘buy all
these 1950s economic sectors,’ next economy theory says ‘look for all the ways
there are to keep the economy going such that we, as a global economy, can thrive
indefinitely.’ In that sense, we argue that current portfolio theory is upside
down. So-called “Modern” Portfolio Theory is backward looking, but wise
investors look forward. We must think
very carefully about asset allocation in the modern economy, and start to
make changes. Traditional asset classes must evolve (“critical power sources”
rather than “oil and gas”, for example), and our portfolios must reflect that
and begin to invest in fully functional enterprises that are both
environmentally and economically sustainable far farther into our future than
current MPT could foresee. But if MPT is all we know, how do we accomplish
that? The only answer to that can be that we have to develop new processes.
Green Alpha’s attempt at that, in some ways
representing a reversal of traditional models of asset management, works like
this:

1. Begin at the highest macroeconomic and ecological levels and
make an objective assessment regarding the most pressing issues confronting
world economies

2. Having identified key issues, the next step is to rigorously
research scientific consensus and new approaches to the technologies, ideas and
business practices best positioned to and most likely to successfully drive
growth while aiding in mitigation of and/or adaptation of issues (such as climate
change and resource scarcity)

3. Of these approaches, then, we ask in the third step which can
practically be deployed or practiced – that is, used in the real world

4. Then, of these working, functional, practical approaches, we
fourth ask which can also be aligned with economic interests such that they can
attract market capital and inspire both entrepreneurs and established companies
to engage. In other words, which can be deployed as profitable businesses

5. Only now, at this point, do we in our fifth step identify
specific companies that come as close as possible to meeting these criteria

6. Looking at granular company-level financial data comes last
for us, and is only applied to qualified next economy companies, as identified
via the five-stage methodology above. In the final step then, we apply
quantitative, rigorous, bottom-up financial analysis to identify stocks of next
economy companies that offer the best financial positions with minimized risk,
with particular focus on growth potential and market liquidity and bankruptcy
risks.

The tools
applied in the final step are universally known and practiced and do not bear
describing here. And in any case this is not the piece of portfolio management
we're redefining. Suffice it to say that from a bottom up fundamental quant
perspective, we don't believe one can improve much Graham-Dodd valuation methodology.

Practicing this
methodology, we arrive at innovative, fully diversified portfolios comprised of
firms that are working now and are positioned to keep working far into the
future as the next economy emerges to displace the fossil fuels economy.

As businesses advance
the better, cheaper, more efficient technologies that do not result in further
warming, increased resource scarcity, deadly pollution, and soil and
groundwater contamination, we can only imagine the productivity, lifestyle and
well-being surges that will be unleashed. So enough with traditional, oil based
economic models.

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